Investment Temptations in an Uncertain Climate

October 4th, 2010

Where to from here? Are we really in for a Japan-style “lost” 20 years, with the stock market delivering a negative return every year for decades? Are you tempted to do things you normally wouldn’t do in order to earn a return on your investments in a very low-interest, low-return world? Is gold the answer? Has real estate run its course? Will the economy slip into another recession? Will you be forced into a government health care program if your employer no longer chooses to offer a health insurance benefit? Will your purchasing power continue to decline as businesses pick up regulatory costs that stifle wage growth?

These are questions we wrestle with on a daily basis. Judging by the nature of the questions, it is no wonder confidence in the economy and in the markets is very weak. In conjunction with weak confidence, equity market valuations are attractive, but buyers are scarce.

Each one of these questions is worthy of its own discussion, but for today, we’d like to focus on just two: First, are investors tempted to do things they normally wouldn’t do as they attempt to find a return on their investments? Second, is gold the answer? The short answers are yes and no, but let us explain.

Investment Temptations

Our current investment environment is nothing short of a conundrum (defined by Merriam-Webster as “an intricate and difficult problem”). Interest rates are at or near historical lows—which is great if you need to borrow money, but not so good if you want a return. The Federal Reserve has communicated, loudly and clearly, that it is not going to raise interest rates any time soon; we believe they may wait more than a year. The market on Fed Fund futures indicates that short-term rates will remain below 0.5% well into 2012.

All of these factors are forcing investors to look into investments they normally wouldn’t consider in an effort to earn a higher return—including buying longer-term U.S. Treasury debt, buying higher-yielding junk bonds and investing in emerging-market debt. In the short term (3 to 6 months), this may work in the investor’s favor. However, bond investors who choose these options can get hurt badly and quickly when interest rates move higher from record-low levels. We offer this warning not to scare investors, but to send a clear message that they must be aware of the increased risk profile in the fixed-income market for what is perceived as a “safe” asset at a time of historically low yields.

A simple illustration is what happened to the long-term U.S. Treasury bond just last year. Yields on the 30-year Treasury started 2009 at 2.67% and ended the year at 4.64%. The total return on the U.S. government long bond for 2009 was -25.98%! The relationship between total return and changes in interest rates is simple—bond prices go in the opposite direction of interest rates. When interest rates go higher, bond prices go lower, meaning total return can be negative. Our current market environment appears to be setting the stage for another very difficult period for long bond investors relative to total return. As difficult as it is to hold cash in a near 0.0% yield environment, the risk of moving into longer bonds to earn a higher yield simply isn’t prudent at this point.

At Bell State Bank & Trust, our strategy continues to be defensive in nature, as we balance the trade-off between giving up yield and cash flow for the sake of principle preservation. These are very challenging times in the fixed-income market. We continue to invest strategically across a broad spectrum of asset types to protect our clients’ assets and, at the same time, strive to deliver an acceptable income stream.

Is Gold the Answer?

The second question is whether gold is a good investment option right now as many seem to believe. Let us remember that gold is simply an industrial commodity that produces no return to the investor outside of simple price movement. There is no yield, there is no dividend and it generates no earnings stream. In fact, there is a cost to own gold, as investors need to take money out of interest- or dividend-earning investments to buy it. This creates a lost income stream for the investor. This lost income needs to be considered as part of the total return on the gold investment, which is purely speculative in nature.

Historically, investors have perceived gold as a store of value: a hedge against inflation and an alternative to more traditional investments. Is gold the answer? Let’s consider how this commodity has fared over time.

From the perspective of an inflation hedge, if we look back 30 years, gold started 1980 at $541. It is currently trading at $1,240 which results in an annual average return of 2.8%. Over the same time period, inflation, as measured by the consumer price index (CPI), has averaged 3.8%. For gold to have kept up with inflation over the past 30 years, it would need to be trading at $1,656—so it has underperformed inflation over this period by 33.5%. If we compare this to the stock market (S&P 500), the S&P started 1980 at 107.9. Today it is trading at 1,042.

On simple price appreciation alone, the average annual stock market return has been 7.85%. Include the reinvestment of dividends, and the return moves up approximately 1.25% to 9.1% annually, well ahead of both the appreciation in gold (2.8%) and inflation (3.8%). Different time periods will obviously produce different results, but the point is that over long periods of time, gold can disappoint investors.

Another way to look at gold is to compare how much gold is required to buy one unit of the stock market (S&P 500). Going back to 1975, the average cost to buy one unit of the stock market has been 1.55 ounces of gold. A simple relationship to determine whether or not gold is expensive relative to the stock market is to look at how it compares to this average rate of 1.55 ounces. In June of 1980, it took only 0.17 ounces of gold to buy 1 unit of the stock market. The S&P was trading near 110, and gold was trading near $665/ounce. At that point, gold would have been perceived as very expensive relative to stocks. Fast forward to the stock market peak in early 2000 following the Y2K and technology bubble. In March 2000, it took 5.38 ounces of gold to buy one unit of the stock market. Gold was cheap relative to the stock market. The S&P was trading at 1,552 a share, while gold was at $288/ounce. The ratio of gold to stock at 5.38 was well over the average of 1.55. High ratio, gold is cheap. Low ratio, gold is expensive.

So where are we today? Currently, the stock market-to-gold ratio stands at 0.85. The stock market is at 1,047, and gold is at $1,240. Gold is back to being a low-ratio, expensive investment relative to stocks over the past 35 years.

Is gold the answer? No one knows what the future holds, and gold has a place in many portfolios. As with many things in life, moderation is the key. Current valuations would indicate that gold is not an attractive buy at these levels, and historically, it can lag inflation by a meaningful amount. That said, in today’s global financial environment, many uncertain investors seem to be finding comfort in owning gold. Is it a crowded and over valued trade? Maybe. Is there more room to run based on uncertainty and fear? Possibly.

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